First, he must stop the economy from going deeper into recession. Then he
needs to bring about a robust recovery, preferably in ways that support the
long-term needs of the United States: by repairing our neglected public works,
invigorating our technological leadership, making our society greener, fixing
our health care problems, healing our social and economic divide, and restoring
our social compact.

It will not be easy. President Bush’s legacy of debt and the opposition of
those who benefit from the status quo present major obstacles.

There is an emerging consensus among economists that a big — very big —
stimulus is needed, at least $600 billion to $1 trillion over two years. Mr.
Obama’s announced goal of 2.5 million new jobs by 2011 is too modest. In the
next two years, almost four million workers will enter the labor force — or
would if there were jobs. Combined with the loss of employment this year, that
means we should be striving to create more than five million jobs.

Saturday, November 29, 2008

There has been much debate about whether the financial crisis is driven by
lack of liquidity or from fears about lack of adequate capital and solvency, but
I'm starting to think a third component is important as well, the complete
breakdown of traditional information flows, and a loss of confidence in the
models used to evaluate that information. Markets need information to work properly, and the information financial markets need is not available.

For example, investors can no longer trust what ratings agencies tell them. A crucial
piece of information, information designed to break informational asymmetries
between firms and investors, turned out to be unreliable. In addition, investors
can no longer believe the numbers they see on bank books. The numbers might say
the bank is solvent, but how reliable are those numbers? And even if the numbers
are meaningful today, will they be meaningful tomorrow? Is there any way to
actually value the assets a lot of these banks have on their books when there is
essentially no market for them, no way to engage in price discovery? Investors
no longer trust analysts and the models they use. They watched the business
channel dutifully and all they heard was about the gold mine in housing. Sure,
there were a few voices on the other side, but they were in the minority and
mostly marginalized. All that bullish advice about housing turned out to be
wrong. And there's no reason investors should trust the models used to process
information either. The models used for risk assessment turned out to be far
wide of the mark - a costly deviation - and if you go back and look at the Fed's
forecasts of coming economic conditions (or the forecasts coming from the
regional banks), it's very clear the models were underestimating the severity
and length of the downturn, enough so to be relatively useless. At a more
individual, face to face level, I suspect their are many homeowners who believed
what their real estate or mortgage broker told them are now wondering how they
could have been so foolish. They won't believe them next time. They won't know
what to believe.

As I think through each stage of the mortgage process and what has gone
wrong, it seems to me that the traditional information flows that are needed for
people to make economic decisions, especially risky ones, are no longer present,
or if they are present, simply not believed. And without the information people
need to make decisions, the markets freeze up.

It's the feeling you have when you suddenly discover that everything you
thought you knew about something, something you believed and relied upon for
years, is wrong (like when you find out something your parents told you just
isn't so). Those are moments that can stop you in your tracks while you
reevaluate and figure out what it all means, while you take time to figure out
how you should respond in the future.

We have recognized that liquidity and solvency are problems, and we have
directed policy to try to address those problems, but I am not sure we are
devoting enough attention to repairing the collapsed information structure. You
can get around the problem through government guarantees or other types of insurance, but
those create other problems, so it's best to avoid this if possible. However,
it's going to be difficult to convince people they can trust this information
again, people won't easily believe a ratings agency, real estate agent, risk
assessment model, etc. just because someone announces that the problems are all
fixed now, models can't be repaired overnight, so on some fronts time may be the only real solution. But on other
fronts, perhaps we can do better. This is not my area, so maybe what we can do
is limited here too, but is there more that the government could do, for
example, with accounting standards or required disclosures that would help
people evaluate the stability of a particular institution? Are there changes
that could be made to give buyers and sellers more confidence that the people
acting as their agents in the transaction have the right incentives?
Is there some way to immediately change the regulation and structure of the
ratings agencies that can help to restore confidence in their assessments of
risk? The point is that we need to move now to start repairing the problems
that are limiting the availability of information needed for these markets to
function.

Perhaps the most important thing the government could provide is confidence
in bank balance sheets. There are lots of ways to do this, e.g. the government
could purchase toxic assets through auctions, and the auctions would serve as
value discovery mechanisms, the government could flood the banks with capital so
that there was no doubt about their solvency, or it could simply put a price
floor under some of the assets on the books, i.e. say that they stand ready to
buy any and all of a particular class of asset at a pre-set price (heavily
discounted). People could then put a lower bound on the value of the asset side
of the balance sheet, and they wouldn't have to worry that the banks own actions
or events outside the institutions control - an unanticipated failure of another
bank that undermines a class of assets in its portfolio - won't suddenly change
it's balance sheet position beyond a known amount. Somehow people need to be
able to evaluate the bounds of the risks they are taking.

Big shocks don't necessarily shake the informational foundations of markets. There can be an event that occurs in the tail of
the distribution of possible events that is viewed as just that, an unusual,
costly event, but not one that fundamentally upsets our understanding of how the
world works while at the same time undercutting the informational flows we use
to understand these markets. I don't think the dot.com crash, for example,
caused us to question the reliability of the information we receive the way this
episode has. After the crash, we still thought we understood how to use models
to process reliable information. But this crisis has destroyed confidence in the
information and the models we use, and it won't be easy to bring this back.

As noted above, while there may be some steps the government can take to
help, solving this problem won't be easy, it will take time to repair the models
and the information flows. That will eventually happen, but in the short-run the government must
find some way around the problem. One way, the best way I can think of, is
through insurance (e.g. the price floor above) and I hope we will see more
movement along these lines. The deal with Citibank can be viewed as a step in
this direction (there is a 29 billion dollar deductible and a 10% copay in the
insurance they were provided -
see the update at the end of this post), but more can be done - more must be done - to overcome
the lack of reliable information in these markets.

Keep as much economic activity as possible under private-sector control, in
order to ensure that what is produced is what consumers really want.

Prevent the princes of Wall Street ... from profiting from the systemic risk
that they created.

Ensure that homeowners and small investors do not absorb too much loss, for
their only "crime" was to accept bad risks, which they would not have done in a
world of properly diversified portfolios.

Now it is clear that the Fed and the Treasury have lost the game. If a
depression is to be avoided, it will have to be the work of other arms of the
government, with other tools and powers.

The failure to contain the crisis will ultimately be traced, I think, to
excessive concern with the first two subsidiary objectives: reining in Wall
Street princes and keeping economic decision-making private. Had the Fed and the
Treasury given those two objectives their proper - subsidiary - weight, I
suspect that we would not now be in this mess...

The desire to prevent the princes of Wall Street from profiting from the
crisis was reflected in the Fed-Treasury decision to let Lehman Brothers
collapse... The logic behind that decision was that, previously in the crisis,
equity shareholders had been severely punished...

But this was not true of bondholders and counterparties, who were paid in
full. The Fed and Treasury feared that the lesson being taught in the last half
of 2007 and the first half of 2008 was that the US government guaranteed all the
debt and transactions of every bank and bank-like entity that was regarded as
too big to fail. That, the Fed and the Treasury believed, could not be healthy.

Lenders to very large overleveraged institutions had to have some incentive
to calculate the risks. But that required, at some point, allowing some bank to
fail...

In retrospect, this was a major mistake. ... With that guarantee broken by
Lehman Brothers' collapse, every financial institution immediately sought to
acquire a much greater capital cushion..., but found it impossible to do so. The
Lehman Brothers bankruptcy created an extraordinary and immediate demand for
additional bank capital, which the private sector could not supply.

It was at this point that the Treasury made the second mistake. Because it
tried to keep the private sector private, it sought to avoid partial or full
nationalization of the components of the banking system deemed too big to fail.
In retrospect, the Treasury should have identified all such entities and started
buying common stock in them - whether they liked it or not - until the crisis
passed.

Yes, this is what might be called "lemon socialism," creating grave dangers
for corporate control, posing a threat of large-scale corruption, and
establishing a precedent for intervention that could be very dangerous down the
road.

But would that have been worse than what we face now? The failure to
sacrifice the subsidiary objective of keeping the private sector private meant
that the Fed and the Treasury lost their opportunity to attain the principal
objective of avoiding depression.

Of course, hindsight is always easy. But if depression is to be avoided, it
will be through old-fashioned Keynesian fiscal policy: the government must take
a direct hand in boosting spending and deciding what goods and services will be
in demand.

Friday, November 28, 2008

More from Paul Krugman. This is from the New York Review of Books (there's much more in the original):

What to Do, by Paul Krugman, NY Review of Books: What the world needs right
now is a rescue operation. The global credit system is in a state of paralysis,
and a global slump is building momentum as I write this. Reform of the
weaknesses that made this crisis possible is essential, but it can wait a little
while. First, we need to deal with the clear and present danger. To do this,
policymakers around the world need to do two things: get credit flowing again
and prop up spending.

The first task is the harder of the two, but it must be done, and soon.
Hardly a day goes by without news of some further disaster wreaked by the
freezing up of credit. ...

Even if the rescue of the financial system starts to bring credit markets
back to life, we'll still face a global slump that's gathering momentum. What
should be done about that? The answer, almost surely, is good old Keynesian
fiscal stimulus. ...

I believe not only that we're living in a new era of depression economics,
but also that John Maynard Keynes—the economist who made sense of the Great
Depression—is now more relevant than ever. Keynes concluded his masterwork, The General Theory of Employment, Interest and
Money, with a famous disquisition on the importance of economic ideas: "Soon
or late, it is ideas, not vested interests, which are dangerous for good or
evil."

We can argue about whether that's always true, but in times like these, it
definitely is. The quintessential economic sentence is supposed to be "There is
no free lunch"; it says that there are limited resources, that to have more of
one thing you must accept less of another, that there is no gain without pain.
Depression economics, however, is the study of situations where there is
a free lunch, if we can only figure out how to get our hands on it, because
there are unemployed resources that could be put to work. The true scarcity in
Keynes's world—and ours—was therefore not of resources, or even of virtue, but
of understanding.

We will not achieve the understanding we need, however, unless we are willing
to think clearly about our problems and to follow those thoughts wherever they
lead. Some people say that our economic problems are structural, with no quick
cure available; but I believe that the only important structural obstacles to
world prosperity are the obsolete doctrines that clutter the minds of men.

Financial reform and regulation of the shadow banking system cannot wait:

Lest We Forget, by Paul Krugman, Commentary, NY Times: A few months ago I
found myself at a meeting of economists and finance officials, discussing — what
else? — the crisis. There was a lot of soul-searching going on. One senior
policy maker asked, “Why didn’t we see this coming?”

There was, of course, only one thing to say...: “What do you mean ‘we,’ white
man?”

Seriously, though, the official had a point. Some people say that the current
crisis is unprecedented, but ... there were plenty of precedents... Yet these
precedents were ignored. And the story of how “we” failed to see this coming has
a clear policy implication — namely, that financial market reform ... shouldn’t
wait until the crisis is resolved. ...

Why did so many observers dismiss the obvious signs of a housing bubble, even
though the 1990s dot-com bubble was fresh in our memories?

Why did so many people insist that our financial system was “resilient,” as
Alan Greenspan put it, when in 1998 the collapse of a single hedge fund,
Long-Term Capital Management, temporarily paralyzed credit markets around the
world?

Why did almost everyone believe in the omnipotence of the Federal Reserve
when its counterpart, the Bank of Japan, spent a decade trying and failing to
jump-start a stalled economy?

One answer ... is that nobody likes a party pooper. While the housing bubble
was still inflating, lenders[, investment banks, and money managers] were making
lots of money... Who wanted to hear from dismal economists warning that the
whole thing was, in effect, a giant Ponzi scheme?

There’s also another reason the economic policy establishment failed to see
the current crisis coming. ... [T]he crisis of 1997-98... showed that the modern
financial system, with its deregulated markets, highly leveraged players and
global capital flows, was becoming dangerously fragile. But when the crisis
abated, the order of the day was triumphalism, not soul-searching.

Time magazine famously named Mr. Greenspan, Robert Rubin and Lawrence Summers
“The Committee to Save the World”... who “prevented a global meltdown.” In
effect, everyone declared ... victory..., while forgetting to ask how we got so
close to the brink in the first place.

In fact, both the crisis of 1997-98 and the bursting of the dot-com bubble
probably had the perverse effect of making both investors and public officials
more, not less, complacent. Because neither crisis quite lived up to our worst
fears,... investors came to believe that Mr. Greenspan had the magical power to
solve all problems — and so, one suspects, did Mr. Greenspan himself, who
opposed ... prudential regulation of the financial system.

Now we’re in the midst of another crisis, the worst since the 1930s. For the
moment, all eyes are on the immediate response to that crisis. ...

And because we’re all so worried about the current crisis, it’s hard to focus
on the longer-term issues — on reining in our out-of-control financial system,
so as to prevent or at least limit the next crisis. Yet the experience of the
last decade suggests that we should be ... regulating the “shadow banking
system” at the heart of the current mess, sooner rather than later.

For once the economy is on the road to recovery, the wheeler-dealers will be
making easy money again — and will lobby hard against anyone who tries to limit
their bottom lines. Moreover, the success of recovery efforts will come to seem
preordained, even though it wasn’t, and the urgency of action will be lost.

So here’s my plea: even though the incoming administration’s agenda is
already very full, it should not put off financial reform. The time to start
preventing the next crisis is now.

How important is the lender of last resort role played by central banks?:

Financial markets and a
lender of last resort, by Eric Hughson and Marc Weidenmier, voxeu.org: The
recent subprime mortgage crisis raises serious questions about the role of a
lender of last resort and the appropriate role of monetary policy. Academics,
policymakers, and the financial press have debated the extent to which central
banks should intervene in the marketplace, provide liquidity, and even purchase
the non-performing assets of troubled financial institutions. Although
economists, Washington insiders, and the media may debate the extent to which
the lender of last resort function should be intensified in wake of the current
financial market meltdown, proponents and opponents of monetary policy generally
agree that it is very difficult to identify the effect of the lender of last
resort function on financial markets.

Fortunately, history provides some insight into the importance of a lender of
last resort in dealing with a financial crisis, especially the provision of
liquidity by financial institutions to help cash-strapped firms in the short
run. Following the Panic of 1907, which was accompanied by one of the shortest
but most severe financial crises in American history, the US Congress passed two
important pieces of legislation that established a lender of last resort: (1)
the Aldrich Vreeland Act of 1908 which allowed banks to temporarily increase the
money supply during a financial crisis, and (2) the Federal Reserve Act of 1913
which replaced Aldrich-Vreeland and established a public central bank in the US
(Moen and Tallman, 2000).

The two acts were designed to increase the elasticity of the money supply,
which was largely fixed by the supply of gold and the requirement that banks
could only issue notes if they were sufficiently backed by US government bonds.
The money supply was especially inelastic during the fall harvest seasons when
the financial markets tended to be illiquid as cash moved from the money centre
banks to the interior to finance the harvesting of crops. The financial
stringency made New York financial market vulnerable to banking and financial
crises in the fall as financial institutions were often forced to call in stock
market loans in response to large unexpected withdrawals of cash in response to
a greater than expected harvest season. Indeed, several of the largest financial
crises of the National Banking Period (1870-1913) occurred during the fall
harvest season including 1870, 1890, 1893, and 1907 (Kemmerer, 1910; Miron,
1986; Sprague, 1910).

Thursday, November 27, 2008

Martin Wolf says "
one of the big lessons of this experience is that economics is too compartmentalized":

A time
for humility, Speech by Martin Wolf, FT: Last year I enjoyed telling a
number of entirely unfair jokes about economists. This year, I looked at the
same source and found only one joke about the profession’s involvement in
depressions. Here it is:

Such a severe depression and banking crisis could not have been achieved by
normal civil servants and politicians, it required economists’ involvement.

This, in short, is a time for humility. Why did we mostly get “it” so
sensationally wrong? ... It is a pretty good question. It is a pretty
embarrassing one, too. It is one everybody I meet now asks. ...

Perhaps this was more than could reasonably be expected. But I do think we
need to ask ourselves whether we could have done a better job of understanding
the processes at work.

The difficulty was that we all tend to look at just one bit of the clichéd
elephant in the room. Monetary economists looked at monetary policy. Financial
economists looked at risk management. International macroeconomists looked at
global imbalances. Central bankers focused on inflation. Regulators looked at
Basel capital ratios and even then only inside the banking system. Politicians
enjoyed the good times and did not ask too many questions. And what of
commentators? Well, they tended to indulge in the fantasy that the above knew
what they were talking about. I am embarrassed to admit this.

I am not seeking to deny that a few people saw important pieces of the
emerging puzzle and some saw more than a few pieces. ... But I would insist that
one of the big lessons of this experience is that economics is too
compartmentalised and so, too, are official institutions. To get a full sense of
the risks being run, we needed to combine the worst scenarios of each sets of
experts. Only then would we have had some sense of how the global imbalances,
inflation targeting, the impact of China, asset price bubbles, financial
innovation, deregulation and risk management systems might interact.

Alternatively, we could have spent more time studying the work of Hyman
Minsky. We could also have considered the possibility that, just as Keynes’s
ideas were tested to destruction in the 1950s, 1960s and 1970s, Milton
Friedman’s ideas might suffer a similar fate in the 1980s, 1990s and 2000s. All
gods fail, if one believes too much. Keynes said, of course, that “practical men
… are usually the slaves of some defunct economist”. So, of course, are
economists, even if the defunct economists are sometimes still alive.

These might seem idle thoughts: these errors are now bygones. But what if we
are now making new and even bigger errors in rushing back to Keynes? The thought
worries me. What if now that households in the US and UK are no longer able, or
willing, to borrow any more, we are set on breaking the back of taxpayers,
instead? Is the end of this crisis the destruction of the credit of some of the
world’s most creditworthy governments? It is a thought I would like to suppress.
But it haunts me. It should haunt you, too. ...

One might not expect much from economists, but one would surely expect them
to warn us of a crisis on this scale. Some humility is in order. That is going
to hurt. A humble economist? Surely not.

George Packer wants Wall Street executives to grow up and apologize for their behavior:

The Moral Stage of Wall Street, by George Packer: Swiss bankers are not
known as paragons of transparency and moral accountability, so it’s a nice
surprise to
read that the top officials of UBS, the foundering financial institution
recently bailed out by the Swiss government, will forgo twenty-seven million
dollars in compensation and bonuses. It appears that these Swiss bankers have a
faint pulse of shame.

It has not gone remarked upon enough that their American counterparts
apparently have none. Having brought the American and global economy to its
knees through their reckless, short-sighted, downright stupid investments, and
then looked to the government for a very expensive lifeline, the leaders of
Citigroup, A.I.G., Goldman Sachs, Morgan Stanley, Lehman, and other financial
giants are maintaining a carefully nonchalant public posture. Andrew Cuomo, New
York’s Attorney General, had to hold a threatening press conference on Wall
Street in order to frighten A.I.G. into announcing that raises, bonuses, and
lavish retreats will be suspended. But fear is not the same thing as shame.
Morally speaking, it’s inferior.

The moral code of these Wall Street executives corresponds to stage one of
Lawrence Kohlberg’s
famous stages of morality: “The concern is with what authorities permit and
punish.” Morally, they are very young children. The Swiss bankers are closer to
stage four, most common among late teens, where a concern for maintaining the
good functioning of society takes hold. Stage six, an elaboration of universal
moral principles based on an idea of the good society, is a distant dream for
the titans of global finance.

In private life, extreme indebtedness, bankruptcy, the ruin of those close to
you, and dependence on the government dole are generally thought to be causes
for anguish, self-denial, and a degree of shame. But if you’re a financial
executive with an exalted title, a big enough salary, a deep enough debt, and a
vast enough handout, these same disasters entitle you to go on living and
feeling about yourself much as you did before. You even have a right to think
that the taxpayers owe it to you—that it’s for their own good, not yours. You
don’t have to explain yourself; you certainly don’t have to apologize.

I would like to see these malefactors of great wealth apologize to the
country. I would like to see them organize their own press conference in a
lineup on Wall Street and, in the manner of disgraced Japanese officials, bow
low to the pavement, express contrition, and beg their countrymen’s forgiveness.
Such a scene would go some way toward cleansing the smell of the financial
crisis.

Of course, nothing like this is going to happen. So instead, like the parents
of two-year-olds, the next Congress should summon them to Washington and
publicly punish these executives who, in Kohlberg’s terms, “see morality as
something external to themselves, as that which the big people say they must
do.”

Update: Arnold Kling comments:

I tend to agree with
Tyler Cowen that individual moral propensities are less important than
overall social context. To borrow from a different branch of social psychology,
I would say that Packer is committing the Fundamental Attribution Error.

In my view, the problem comes from trying to use what I call
letter-of-the-law regulation in finance. Call it L regulation. With L
regulation, the regulator lays down specific, quantitative boundaries (think of
risk-based capital requirements, with fixed numerical weights for various types
of assets). The managers of financial institutions are told to stay within those
boundaries.

In contrast, think of something I might call S regulation, for spirit of the
law. With S regulation, the manager of a financial institution that enjoys some
government protection would take an oath to maintain the safety and soundness of
the institution. With S regulation, it is wrong to just tiptoe along the edge of
the quantitative boundaries, without considering the potential risk to the firm.

Suppose we take it as given that government is going to protect some of the
liabilities of some institutions, because of deposit insurance, implicit
guarantees, "too big to fail," or other reasons. I would like to see such
institutions be covered by S regulation even more than by L regulation.

I would like to see managers of government-protected institutions take an
oath to safeguard the soundness of their companies. I would like to see them
subjected to prison terms for violating that oath. The oath is a general
promise, not satisfied simply by staying within the boundaries of L regulation.

I believe that S regulation would change the motives of bank managers. They
would be looking for ways to avoid failure, rather than for ways to stay within
the letter of the law.

There can be plenty of risk-taking institutions in our society. But they
should not at the same time be institutions that enjoy government protection
when they fail.

So are we about to return to Keynesianism? Hopefully. Government is the
spender of last resort, which means the new Obama administration should probably
be considering a stimulus package in the range of $600 billion, roughly 4
percent of national product -- focused on building and repairing the nation’s
crumbling infrastructure, providing help to states to maintain services, and
investing in new green technologies in order to wean the nation off oil.

But between now and late January, when the stimulus package will be voted on,
we're likely to be treated to a great debate over the wisdom of Keynesianism.
...

Conservative supply-siders ... will call for income-tax cuts rather than
government spending, claiming that people with more money in their pockets will
get the economy moving again more readily than can government. They're wrong,
too. Income-tax cuts go mainly to upper-income people, and they tend to save
rather than spend.

Even if a rebate could be fashioned for the middle class, it wouldn't do much
good because, as we saw from the last set of rebate checks, people tend to use
extra cash to pay off debts rather than buy goods and services. Besides,
individual purchases wouldn't generate nearly as many American jobs as
government spending on infrastructure, social services, and green technologies,
because so much of we as individuals buy comes from abroad.

So the government has to spend big time. The real challenge will be for
government to spend it wisely -- avoiding special-interest pleadings and pork
projects such as bridges to nowhere. We’ll need a true capital budget that lays
out the nation’s priorities rather than the priorities of powerful Washington
lobbies. How exactly to achieve this? That's the debate we should be having
between now and January 20 or 21st.

At the end of September 2008, U.S. policymakers had been
working for more than a year to contain the shock waves from plunging home
prices and the subsequent financial market turmoil. For the Federal Reserve, the
crisis has given new meaning to the adage that extraordinary times call for
extraordinary measures. The central bank has dusted off Depression-era powers
and rewritten old rules to address serious risks to the global financial system.

The spreading financial crisis has led the Fed to pump
liquidity into the economy and expand its lending beyond the commercial banking
sector. In March, it assisted with J.P. Morgan Chase’s buyout of Bear Stearns, a
cash-strapped investment bank and brokerage. Six months later, the Fed took
direct action again, with an $85 billion bridge loan to prevent the disorderly
failure of American International Group (AIG), a giant global company heavily
involved in insuring against debt defaults.[1]

These Fed actions—part of a broader U.S. government
effort to contain the financial crisis—call to mind two earlier financial
interventions: in the case of Long-Term Capital Management (LTCM) in 1998 and in
the aftermath of the Sept. 11, 2001, terrorist attacks.

In both episodes, the Fed felt compelled to protect the
financial system from severe shocks and the overall economy from spillovers that
might produce serious downturns. Inherent in the Fed’s moves was a natural
by-product of intervention—moral hazard and the controversy that flows from it.

Concern about moral hazard helps explain why the Fed has
traditionally intervened only rarely and reluctantly, trying to do what’s
necessary, but as little as necessary, to achieve financial stability. Markets
generally should and do self-correct. When potential financial problems arise,
the Fed’s default reaction has usually been to do nothing and let the markets
work their way through the difficulties.

On rare occasions, however, the markets themselves are
at risk of failure. In such cases, the Fed can’t fulfill its obligation to
promote financial stability without direct action. Two factors have strengthened
the case for central bank intervention in the past decade—the financial system’s
increased globalization and the untested nature of the new and complex financial
instruments that have come under stress.

The escalation of what’s now recognized as a global
financial crisis has changed the modus operandi of Fed interventions. The
guiding principle of do what is necessary, but as little as necessary, has been
replaced by the recognition—reinforced by actions—of the importance of doing
whatever it takes to break the downward spiral in the financial and credit
markets that has contaminated the overall economy. With a broad understanding of
the consequences of inaction, the Fed has taken a hard turn toward intervention
in an atmosphere in which fear of moral hazard has been displaced by the reality
of systemic risk’s unacceptable consequences.

Though there is great entertainment in looking back at the silly things
economists have said, more is to be gained by examining the particular failings
that contributed to forecasters’ general inability to warn of the current mess.

First is the unforeseen, but now evident, fragility of the global economy in
the face of a systemic banking collapse. ... Second, as Stephen King, chief
economist of HSBC, says: “Almost all economic models assume that the financial
system ‘works’.” ...

Third was the deep squeeze on household and corporate incomes from the
commodity boom of the first half of 2008, which almost no one predicted. This
weakened the non-financial sector before banks had any chance to repair the
damage from the subprime crisis...

Fourth, most economic models suggest the demand for money will be stable, but
banks and households have now begun to hoard cash. This threatens to make
monetary policy ineffective..., something that is
not generally factored into forecasting models.

Fifth is an over-reliance on the output gap – the difference between the
level of output and an estimate of what is sustainable – in forecasting. That
allowed policymakers to believe everything was fine ... because inflation was
under control and growth was not excessive.

Sixth is the natural tendency to seek rationales for events as they unfold,
rather than question whether they are sustainable. ...

Mention must ... be given to the notable voices of doom, who got important
bits of the puzzle correct even if the timing or other details eluded them. Prof
Roubini ... wrote a paper with Brad Setser in August 2004 predicting that the
world’s trade imbalances were unsustainable and likely to “crack the system in
the next three to four years”. He has been prescient in understanding the links
between financial markets and the real economy.

William White, the former chief economist of the Bank for International
Settlements, the central bankers’ bank in Basel, Switzerland, was a persistent
critic of lax monetary policy and the failure to stem credit expansion. Prof
Rogoff also spotted the dangers of unsustainable global economic expansion in a
2004 paper with Maurice Obstfeld. In more recent work with Carmen Reinhart he
has highlighted how policymakers fell into the “this time it’s different” trap
that dates back to England’s 14th-century default.

Prof Persaud has made an honest living for many years warning about the
fallibility of value-at-risk models and the tendency for them to encourage herd
behaviour. And in the FT’s new year survey of economists for 2008, Wynne Godley
of Cambridge university, also a permanent bear, said: “I think the seizing up of
financial markets may well result in a collapse in lending in the US to the
non-financial sector so large that it causes a recession deeper and more
stubborn than any other for decades – and deeper than anyone else is expecting.”
Quite.

Policymakers, too, have been far from consistently wrong. Mr Trichet dines
out on stories of how he predicted the crisis and cites a Financial Times
article as evidence... Mr King warned for years about the risks evident in the
global economy and the IMF repeatedly warned about the unsustainable level of
house prices.

Willem Buiter ... warns not to be too impressed by some forecasts that have
turned out to be true, because they were lucky, not wise. “Hindsight is
useless,” Prof Buiter insists. ...

Predictive Models: Blown Off Course by Butterflies

In the 1980s, it seemed that computers held the key to economic forecasting,
writes John Kay. With large models and sufficient processing power, predictions
would become more and more accurate.

This dream did not last long. We now understand that economies are complex,
dynamic, non-linear systems...

So economic crystal ball-gazing remains unscientific. The trend is the
forecaster’s friend. Extrapolation assumes that the future will be like the
past, only more so. We project current preoccupations ... with exaggerated speed
and to an exaggerated degree. ...

If extrapolation is the forecaster’s friend, mean reversion is the
forecaster’s crutch. Much of the time, you can predict that next year’s figure
will be somewhere between this year’s level and the long-run average. But mean
reversion never anticipates anything out of the ordinary. Every few years,
out-of-the-ordinary things happen. They just have.

Still, you might think there would be large rewards for those who succeed in
anticipating these events. You would be wrong. People who worried before 2000
that the “new economy” was a bubble, or warned of the terrorist threat before
September 11 2001, or saw that credit expansion was out of control in 2006, were
not popular. They were killjoys.

Nor were they popular after these events. If these people had been right,
then others had been blind or negligent, and the latter preferred to represent
themselves as victims of unforeseeable events. As John Maynard Keynes observed,
it is usually better to be conventionally wrong than unconventionally right.

I've been arguing that government spending is preferable to tax cuts as a
means of stimulating the economy. Via an email from Bob Hall, an
argument against that position from a paper described below:

General Stimulus

Current forecasts have real GDP reach its lowest value in the second quarter
of 2009,... the total shortfall [is] $855 billion.
This figure provides a way to think about the magnitude of a stimulus. Trying to
push spending and output up to its trend level in a short time, would probably
be unwise, for fear of overshooting. Eventually, the corrective forces of the
economy would bring spending and output back to its long-run growth path. Policy
fits in somewhere between, hastening the return to normal.

The case for stimulus is particularly strong with deflation hanging over the
economy. But the Fed has a small amount of room left to stimulate through
reductions in the fed funds rate—its target is currently one percent.

Fiscal stimulus will provide most of the needed boost. Fiscal actions take
two forms, tax cuts and spending increases. Tax cuts raise consumer spending and
business investment and thereby raise output and employment. When we speak of
tax cuts, we include rebates paid to families who pay no income tax and we also
include increase in social benefits, such as unemployment compensation. Spending
increases go directly into higher output. Rebuilding a bridge produces output
included in GDP and raises employment. The spending we are talking about here
involves the government buying goods and services, not paying subsidies or
benefits to families or businesses. Those go in the tax cut bucket. 25

Commentators apart from economists often compare the two types
of policies in terms of bang for the buck. Bang is the amount added to
GDP and thus to employment and buck is the amount of government money
involved, or, equivalently, the addition to the government deficit. By this
measure, spending stimulus comes out ahead of tax-cut stimulus. The spending
automatically enters GDP and may have some second-round effects as well. Some
part of a tax cut goes into saving, so the immediate increase in GDP is probably
smaller. (John
Taylor’s evidence) Earlier this year, the federal government used a tax-cut
stimulus that helped delay the recession. Now advocates of spending stimulus are
using the bang-for-the-buck criterion to argue that it is time to crank up
spending.

Bang for the buck is not the right way to score stimulus
measures. The nation is not limited to any particular level of government outlay
or deficit level. The U.S. federal government has the best credit rating in the
world because its current debt is small in relation to its ability to tax in the
future. If consumers save half of a tax cut, the cut can be made twice as large
as the desired increase in immediate spending.

Instead, the choice between tax cuts and spending increases
should depend on the tradeoff between the value of the increased spending, which
favors tax cuts, and precision of timing, which favors spending increases.
Consumers respond to improved resources, from a tax cut or any other source, by
adding the most valuable spending that they were unable to afford prior to the
improvement. They are bound to spend a tax cut on something they want. By
contrast, the government is not notably successful in picking good spending
projects. Way too much money goes to inefficient operations like Amtrak and to
build multilane interstates in Montana. Unlike the consumer, the government does
not reliably spend extra resources on valuable purchases.

On the other hand, the government can, in principle, concentrate
a spending stimulus in the time when it is most desirable, namely in the next
few months. The government cannot concentrate the spending that consumers choose
to make from a tax cut—part of that spending may occur way too late.
Unfortunately, it is hard for the government to crank up spending quickly. Even
if the government hires contractors quickly to fix creaky bridges, the stimulus
only takes effect when the contractor hires the workers and puts them to work, a
process that takes up to a year.

The government could concentrate the spending from a tax cut
into a brief period with a novel kind of fiscal stimulus, a general consumption
subsidy. Here consumers would receive, say, four percent back from the
government, for consumption purchases in the first three months of 2009. The
credit would be refundable to low-income families and phased out, as the current
income tax does for deductions, for high-income families. The stimulus from this
policy would be concentrated at the time when stimulus is most needed, sooner
than any practical government spending increase. One way to generate the subsidy
is to eliminate state sales taxes for a period. (Kotlikoff-Leamer
proposal)

A second way to concentrate the stimulus is to cut the payroll tax for a
period of a year or two. Half of the immediate benefit would go to employers and
would encourage hiring and retaining workers while the other half would increase
the take-home pay of workers. The employer effect would be in place only during the tax cut, so it is highly concentrated. The
worker half would be more like a standard tax cut, subject to the problem of
consumption deferral. Cutting only the employer part of the tax would be most
effective at targeting the stimulus when most needed.

The text quoted above is from a website maintained by Susan Woodward and Bob
Hall. The goal is to provide analysis of the financial crisis and to recommend
policy responses, i.e. to "update this description of what has happened in the
U.S. economy since the crisis began in 2007 and to give a commentary on the
events and on actual and recommended policies to deal with financial stress and
recession":

Low interest rates in the early part of the decade were responsible monetary
policy to head off deflation, not an irresponsible contribution to a housing
price bubble

The most important fact about the economy today is the collapse of spending
on home building and the resulting recession

The aggressive response of financial policy seems to have contained the
effects of the financial crisis on some key elements of spending, especially
plant and equipment investment, through the third quarter this year

The government is wasting money by not stating a formal guarantee of Fannie
Mae's and Freddie Mac's debt

Proposed and active programs for helping beleaguered homeowners reach only a
small fraction of those in trouble and focus on the wrong goals

The top policy priority is a large stimulus to the overall economy rather
than actions aimed just at housing

Click
here for the pdf containing the analysis with graphs, sources, and
bibliography. Click
here for the Excel file containing the relevant data.

Back to the fiscal policy versus tax cuts question, according to the argument
above, one reason government spending dominates tax cuts is that the private
sector will allocate the money more efficiently than government. Government "is
not notably successful in picking good spending projects," while the private
sector recipients of tax cuts devote the money to "the most valuable spending."

Like purchasing stocks and houses in a bubble, things like that? The private
sector isn't perfect either, some businesses will fail miserably, the resources
are wasted, not every private sector employee is the model of efficiency, and
some consumers will come home with magic beans (you can find roads to nowhere in
the private sector too - they go to housing developments where the streets are
in place, but there's little or nothing built there). So we mean relative
efficiency. I'm not saying the government is just as efficient as the private
sector, only that the relative levels of wasted resources may not be quite as
stark as we sometimes think.

But here's the main question. Suppose we ask, "should we tax consumers and
build a bridge, or should we let consumers keep the money?" If every time we ask
that question the answer is "consumers should keep the money because they are
more efficient," how does infrastructure ever get built? There must be times
when there are public goods - goods the private sector will not build on its own
- that have a net positive value to society. If that's the case, then there is a
role for government to step in and provide those goods. So why
not build what we need now? Tax cuts cannot be aggregated into large sums - the
large amounts of money needed to build major infrastructure projects - but
government can act as an intermediary by pooling the money into sums large
enough to get the job done. This is a time when such pools of money will be
available, so we should take advantage of the opportunity.

To be fair, the question in the previous paragraph is not quite the question Woodward and Hall are asking since it is also desirable to time the policy so as to optimally offset swings in GDP and employment. But I think that objection can be overcome with a combination policy that uses tax cuts to provide an immediate boost with infrastructure spending that maintains the boost over a longer time period.

A combination policy can also help with another problem. It is no easy task to find $700 billion
dollars worth of infrastructure projects that clearly fit into the category of
having net positive value to society. Spending the money just to spend it is wasteful, and
it is detrimental to policymakers in the future who will have to live with
precedent set by actions taken now. So we should invest the money where we get
the most value, and also where it has the best chance of lifting us out of the recession.

Because of that, I would break up the stimulus into pieces, with part of it
going to provide an immediate boost through targeted tax cuts of some sort,
another part would be devoted to providing an ongoing stimulus through infrastructure spending - those projects with
clear positive societal value - and the remainder would go to backfill shortages
at the state and local level, enhance food stamp programs, extend unemployment
insurance, fill lapses in health care coverage due to layoffs, and other such
needs.

Ricardo Caballero and Arvind Krishnamurthy argue that the presence of
Knightian uncertainty in financial markets means that recapitalization of financial institutions must
be massive in order to work, larger than is likely to be practical. However,
another solution - government insurance - can reduce the size of the required
capital injection:

The main implication of rampant uncertainty for the TARP and its relatives,
is that capital injections are not a particularly efficient way of dealing with
the problem unless the government is willing to invest massive amounts of
capital, probably much-much more than the current TARP. The reason is that
Knightian uncertainty generates a sort of double- (or more) counting problem,
where scarce capital is wasted insuring against impossible events.

A simple example makes the point: Suppose two investors, A and B, engage in a
swap, and there are only two states of nature, X and Y. In state X, agent B pays
$1 to agent A, and the opposite happens in state Y. Thus, only $1 is needed to
honour the contract. To guarantee their obligations, each of A and B put up some
capital. Since only $1 is needed to honour the contract, an efficient
arrangement will call for A and B jointly to put up no more than $1. However, if
our agents are Knightian, they will each be concerned with the scenario that
their counterparty defaults on them and does not pay the dollar. That is, in the
Knightian situation the swap trade can happen only if each of them has a unit of
capital. The trade consumes two rather than the one unit of capital that is
effectively needed.

Of course, real world transactions and scenarios are a lot more complex than
this simple example, which is in itself part of the problem. In order to
implement transactions that effectively require one unit of capital, the
government needs to inject many units of capital into the financial system.

But there is a far more efficient solution, which is that the government
takes over the role of the insurance markets ravaged by Knightian uncertainty.
That is, in our example, the government uses one unit of its own capital and
instead sells the insurance to the private parties at non-Knightian prices.

The Knightian uncertainty perspective also sheds light on some of the virtues
of the now defunct asset-purchases programme of the original TARP. ... In such
cases, removing the uncertainty-creating assets from the balance sheet of the
financial institution reduces risk by multiples, and frees capital, more
effectively than directly injecting equity capital.

Does this mean that there is no role for capital injections? Certainly not.
Knightian uncertainty is not the only problem in financial markets, and capital
injections are needed for conventional reasons. Our point is simply that these
injections need to be supplemented by insurance contracts, unless the government
is willing to increase the TARP by an order of magnitude...

You have made yourself the trustee for those in every country who seek to
mend the evils of our condition by reasoned experiment within the framework of
the existing social system. If you fail, rational change will be gravely
prejudiced throughout the world, leaving orthodoxy and revolution to fight it
out. But if you succeed, new and bolder methods will be tried everywhere, and we
may date the first chapter of a new economic era from your accession to office.
This is a sufficient reason why I should venture to lay my reflections before
you, though under the disadvantages of distance and partial knowledge. ...

You are engaged on a double task, recovery and reform - recovery from the
slump and the passage of those business and social reforms which are long
overdue. For the first, speed and quick results are essential. The second may be
urgent too; but haste will be injurious, and wisdom of long-range purpose is
more necessary than immediate achievement. It will be through raising high the
prestige of your administration by success in short-range recovery, that you
will have the driving force to accomplish long-range reform. On the other hand,
even wise and necessary reform may, in some respects, impede and complicate
recovery. For it will upset the confidence of the business world and weaken
their existing motives to action, before you have had time to put other motives
in their place. ...

My second reflection relates to the technique of recovery itself. The object
of recovery is to increase the national output and put more men to work. In the
economic system of the modern world, output is primarily produced for sale; and
the volume of output depends on the amount of purchasing power, compared with
the prime cost of production, which is expected to come on the market. Broadly
speaking, therefore, an increase of output depends on the amount of purchasing
power, compared with the prime cost of production, which is expected to come on
the market. Broadly speaking, therefore, an increase of output cannot occur
unless by the operation of one or other of three factors. Individuals must be
induced to spend more out of their existing incomes; or the business world must
be induced, either by increased confidence in the prospects or by a lower rate
of interest, to create additional current incomes in the hands of their
employees...; or public authority must be called in aid to create additional
current incomes through the expenditure of borrowed or printed money. In bad
times the first factor cannot be expected to work on a sufficient scale. The
second factor will come in as the second wave of attack on the slump after the
tide has been turned by the expenditures of public authority. It is, therefore,
only from the third factor that we can expect the initial major impulse.

The major part of the first stimulus package was the $115 billion, temporary
rebate payment... The argument in favor of these temporary rebate payments was
that they would increase consumption, stimulate aggregate demand... What were
the results? ...[C]onsumption shows no noticeable increase at the time of the
rebate [see
chart]. Hence, by this simple measure, the rebate did little or nothing to
stimulate consumption, overall aggregate demand, or the economy.

These results ... correspond very closely to what basic economic theory tells
us. According to the permanent-income theory of Milton Friedman, or the
life-cycle theory of Franco Modigliani, temporary increases in income will not
lead to significant increases in consumption. However, if increases are
longer-term, as in the case of permanent tax cut, then consumption is
increased...

After years of study and debate,... the permanent-income model led many
economists to conclude that discretionary fiscal policy actions, such as
temporary rebates, are not a good policy tool. Rather, fiscal policy should
focus on the "automatic stabilizers" (the tendency for tax revenues to decline
... and transfer payments such as unemployment compensation to increase in a
recession), which are built into the tax-and-transfer system, and on more
permanent fiscal changes that will positively affect the long-term growth of the
economy. ...

What ... can Congress and the incoming Obama administration do to give the
economy a real boost on Jan. 20? Here are a few fairly bipartisan measures worth
considering:

First, make a commitment, passed into law, to keep all income-tax rates were
they are now, effectively making current tax rates permanent. This would be a
significant stimulus to the economy...

Second, enact a worker's tax credit equal to 6.2% of wages up to $8,000 as
Mr. Obama proposed during the campaign -- but make it permanent rather than a
one-time check.

Third, recognize explicitly that the "automatic stabilizers" are likely to be
as large as 2.5% of GDP this fiscal year, that they will help stabilize the
economy, and that they should be viewed as part of the overall fiscal package
even if they do not require legislation.

Fourth, construct a government spending plan that meets long-term objectives,
puts the economy on a path to budget balance, and is expedited to the degree
possible without causing waste and inefficiency.

Some who promoted the first stimulus package have reacted to its failure by
saying that we must now switch to large increases in government spending to
stimulate demand. But government spending does not address the causes of the
weak economy, which has been pulled down by a housing slump, a financial crisis
and a bout of high energy prices, and where expectations of future income and
employment growth are low.

The theory that a short-run government spending stimulus will jump-start the
economy is based on old-fashioned, largely static Keynesian theories. These
approaches do not adequately account for the complex dynamics of a modern
international economy, or for expectations of the future that are now built into
decisions in virtually every market.

I'll note in passing that the New Keynesian model incorporates expectations of the future, and accounts for complex dynamics as well as any model, so the criticism in the last paragraph is really about policy justified by traditional Keynesian theory, not the more modern version. But more to the point, I don't think anything he said rules out positive net present value
investments in infrastructure. We should make these investments in any case if we want the economy to grow robustly, now
just happens to be a good time to have the construction and maintenance work done since people need jobs,
inputs to production are relatively cheap, and the political atmosphere is
accommodating.

Update: Paul Krugman:

Conservative crisis desperation: So we’re having a crisis, reflecting the policy failures of the past 8 years.
But the usual suspects insist that the crisis is all the more reason to persist
with those policies — indeed, make them permanent.

Thus, John Taylor — a very good economist, when he wants to be — insists that
we must respond to the economy’s temporary weakness with a permanent tax cut.
Let us reason together. Does it make sense to let one recession dictate tax
policy in perpetuity? What happens if there’s a boom; can we increase taxes (no,
because then the cut wouldn’t have been permanent.) What if there’s another
recession? Do we permanently cut taxes again? Is there a tax-cut ratchet (or
maybe racket)? Think this through, and it makes no sense at all.

And Taylor’s argument against the obvious answer — government spending as
stimulus — is pure gobbledygook:

The theory that a short-run government spending stimulus will jump-start the
economy is based on old-fashioned, largely static Keynesian theories. These
approaches do not adequately account for the complex dynamics of a modern
international economy, or for expectations of the future that are now built into
decisions in virtually every market.

Translation: la la la I can’t hear you.

Meanwhile, at a panel discussion with Rich Lowry of National Review,
I heard the latest argument against the Employee Free Choice
Act: now would be a really bad time to make union organizing easier, because
it would hurt business confidence in a recession.

Recession, recovery, whatever: it’s always proof that the Bush years should
continue forever.

The lending facility, which will be operated by the Federal Reserve, is
expected to provide loans to investors who want to buy securities backed by
credit cards, auto loans and student loans ... Treasury will contribute between
$25 billion to $100 billion to the facility from its $700 billion Troubled Asset
Relief Program.

The whole subject of the liquidity trap has a sort of
Alice-through-the-looking-glass quality. Virtues like saving, or a central bank
known to be strongly committed to price stability, become vices; to get out of
the trap a country must loosen its belt, persuade its citizens to forget about
the future, and convince the private sector that the government and central bank
aren’t as serious and austere as they seem.

Virtue is vice; vice, virtue. But this view is not shared by everyone. In a
weekend New York Times column on the New Deal, Tyler Cowen
writes:

The good New Deal policies, like constructing a basic social safety net, made
sense on their own terms and would have been desirable in the boom years of the
1920s as well. The bad policies made things worse. Today, that means we should
restrict extraordinary measures to the financial sector as much as possible and
resist the temptation to “do something” for its own sake.

So what's the right approach? Interestingly, Mr Cowen's column cites the
work of Christina Romer, the
Berkeley economist recently tapped to run Barack Obama's Council of Economic
Advisers. He says:

Some people are claiming that Obama's job package will cost $280,000 per job. The actual cost is not trivial,
but I don't think that figure is correct (it simply divides a proposed stimulus
amount, $700 billion, by the stated job goal of 2.5 million). I've also seen the
claim that the $700 billion number is simply pulled out of a hat, but that's not
right either, it's based upon transparent calculations.

The Bureau of Labor Statistics
announced last week
that the seasonally adjusted consumer price index fell by 1% during the month of
October, implying an annual deflation rate around -12%. That's the biggest
monthly drop in the CPI since publication of seasonally adjusted changes began
in February 1947. The core CPI (excluding food and energy) saw its first decline
in a quarter century.

Does this mean that deflation is now upon us?
Mike Bryan argues that despite the indication from the headline and core
CPI, actual decreases in prices were not that widespread in October. ...

So maybe everything's OK? I think not. Two forward-looking indicators are
profoundly troubling. First, the yields on inflation-indexed Treasuries for
medium-term maturities are actually higher than those for regular Treasuries. If
taken at face value, that means investors anticipate an average deflation
over the next 5 years at a -1.29% annual rate. Perhaps one might dismiss this as
another indication that the usual arbitrage activity is
completely absent in current markets, so that the nominal-TIPS spread is no
longer a meaningful indicator. ...

But a second and equally troubling suggestion of expected deflation is the
extremely low yields on short-term Treasury bills. Again there may be those who
interpret this not as a harbinger of deflation but instead as a reflection of
the astonishing (and equally frightening) flight to quality that we have been
witnessing.

Johm Hempton disagrees with me and others that the problem in financial
markets is fundamentally one of solvency, i.e. lack of adequate bank capital. He
says it is a matter of trust, trust that was destroyed by lies and deceptive
practices among other things. If he is right, bank recapitalization alone will not bring back the
trust that is needed - well capitalized banks can still lie - and because of
that he believes some sort of "full guarantee of all sorts of bank debt" is
needed to get bank credit flowing again from financial wholesalers to financial
intermediaries. His preferred solution to provide the necessary trust is bank
nationalization - the government won't default on its obligations to provide
payment - and this allows taxpayers to fully participate in the upside in return
for assuming the risk inherent in guaranteeing debt payments:

• Citigroup had poor risk controls.
• As a result, the bank owned $43 billion of mortgage-related assets that it
incorrectly thought were safe.
• They weren't.
• And so as a result the market value of Citi has collapsed by a factor of ten:
from $200 billion to $20 billion.

To which the only appropriate response is: "Huh?" How can losses out of $43
billion of optimistically overvalued asserts eliminate $224 billion of value?
Eric Dash and Julie Creswell don't answer that question. They don't even seem to
recognize that it is a question that they should be interested in. That they
were given this story to write, and that no editors said "wait a minute! this
doesn't add up!" is yet another signal that the New York Times is in its death
spiral: not the place to go to learn anything about an issue.

I think he is a little rough to criticise the NYT for that – or for that
matter any other paper – because at the moment the Treasury and the FDIC are
also acting (at least until now) as if they do not know the answer.

The answer is that the crisis is not about the amount of losses yet realised
or yet to be realised, and it is not about capital adequacy of the banks and it
is not about their level of leverage. It is simply about the question “do we
trust them to repay their debts”. You might think is about capital or losses or
leverage – but even if the bank has adequate capital and losses come are
relatively small if we believe collectively that they can’t repay then they
can’t repay. Sure more capital would produce more trust – but the level of
distrust at the moment is so high that nobody can tell you how much capital is
needed. All estimates are a shot in the dark. In reality all that is needed is
more trust.

The short answer to the Brad deLong question is that due to the losses and
the lack of risk control people stopped believing in Citigroup – and hence
Citigroup dies without a bailout. It was however pretty easy to stop believing
in Citigroup because nobody (at least nobody normal) can understand their
accounts. I can not understand them and I am a pretty sophisticated bank
analyst. I know people I think are better than me – and they can’t understand
Citigroup either. So Citigroup was always a “trust us” thing and now we do not
trust.

The long answer has to be a replay of the various themes of this blog. So
lets do it in pieces.

Good Bank, Bad Bank, and F---ed Bank: Apparently Citibank and the U.S.
government (i.e., we taxpayers) have reached a deal whereby we will backstop
something like $300-billion in screwed assets on Citi's balance sheet. ... Here
is the gist:

Citi will carve out $300-billion in troubled assets, which will remain on
its balance sheet

The first $37-$40-billion in losses on those assets will go to Citi

The next $5-billion in losses will hit Treasury

The next $10-billion in losses will go to the FDIC

Any more losses will go to the Fed

There will be no management changes at Citi, because, you know, they are all
fine and upstanding people who have done nothing wrong

There will be some compensation limitations, but those have not yet been
made clear

To be clear, this is not a "bad bank" model. Assets are not, apparently,
being taken off the Citi balance sheet and put into another entity walled off
from the Citi biological host. Instead, they are being left on the Citi balance
sheet, but tagged and bagged for eventual disposal via taxpayers. ...

I'll have more when there is more, and I know the equity futures markets like
it -- it's admittedly less terrifying that letting Citi fail -- but so far I'm
not impressed. ...

Yves Smith:

WSJ: US Agrees to Bail Out Citi (Updated): ...Note key element of the
deal is that the Federal government will guarantee $300 billion of Citi assets,
a much bigger number than had been leaked earlier, with a rather convoluted
loss-sharing arrangement, but the bottom line is that Citi is at risk for at
most $40 billion. Citi also gets a $20 billion equity injection, on slightly
more onerous terms than the initial TARP investments, but still more favorable
than Warren Buffett's investment in Goldman. Oh, and it appears there will be NO
management changes.

I do not see how GM can be denied a rescue now (not that that outcome is really
in doubt, merely how much pain will be inflicted on management and the UAW). ...

Citigroup Bailout: Weak, Arbitrary, Incomprehensible: According to the Wall
Street Journal, the deal is done. Here are the terms. In short: (a) Citi gets
another $27 billion on the same terms as the first $25 billion, except that the
interest rate is now 8% instead of 5%, and there is a cap on dividends of $0.01
per share per quarter; and (b) the government (Treasury, FDIC, Fed) agrees to
absorb 90% of losses above $29 billion on a $306 billion slice of Citi’s assets,
made up of residential and commercial mortgage-backed securities. (If triggered,
some of that guarantee will be provided as a loan from the Fed.) There is also a
warrant to buy up to $2.7 billion worth of common stock (I presume) at a
staggeringly silly price of $10.61 per share (Citi closed at $3.77 on Friday).

The government (should have) had two goals for this bailout. First, since
everyone assumes Citi is too big to fail, the bailout had to be big enough that
it would settle the matter once and for all. Second, it had to define a standard
set of terms that other banks could rely on and, more importantly, the market
could rely on being there for other banks. This plan fails on both counts.

The arithmetic on this deal doesn’t seem to work for me (feel free to help me
out). Citi has over $2 trillion in assets and several hundred billions of
dollars in off-balance sheet liabilities. $27 billion is a drop in the bucket.
Friedman Billings Ramsey last week estimated that Citi needed $160 billion in
new capital. (I’m not sure I agree with the exact number, but that’s the
ballpark.) Yes, there is a guarantee on $306 billion in assets (which will not
get triggered until that $27 billion is wiped out), but that leaves another $2
trillion in other assets, many of which are not looking particularly healthy. If
I’m an investor, I’m thinking that Citi is going to have to come back again for
more money.

In addition, the plan is arbitrary and cannot possibly set an expectation for
future deals. In particular, by saying that the government will back some of
Citi’s assets but not others, it doesn’t even establish a principle that can be
followed in future bailouts. In effect, the message to the market was and has
been: “We will protect some (unnamed) large banks from failing, but we won’t
tell you how and we’ll decide at the last minute.)” As long as that’s the
message, investors will continue to worry about all U.S. banks.

The third goal should have been getting a good deal for the U.S. taxpayer,
but instead Citi got the same generous terms as the original recapitalization.
8% is still less than the 10% Buffett got from Goldman; a cap on dividends is a
nice touch but shouldn’t affect the value of equity any. By refusing to ask for
convertible shares, the government achieved its goal of not diluting
shareholders and limiting its influence over the bank. And an exercise price of
$10.61 for the warrants? It is justified as the average closing price for the
preceding 20 days, but basically that amounts to substituting what people really
would like to believe the stock is worth for what it really is worth ($3.77).

How does this kind of thing happen? A weekend is really just not that much
time to work out a deal. Maybe next time Treasury and the Fed should have a plan
before going into the weekend?

What, and ruin a perfect record? Robert Reich:

Citigroup Scores: If you had any doubt at all about the primacy of Wall
Street over Main Street; the utter lack of transparency behind the biggest
government giveaway in history to financial executives, and their shareholders,
directors, and creditors; and the intimate connections the lie between
Administrations -- both Republican and Democratic -- and the heavyweights on
Wall Street, your doubts should be laid to rest. Today it was decided the
government will guarantee more than $300 billion of troubled mortgages and other
assets of Citigroup under a federal plan to stabilize the lender after its stock
fell 60 percent last week. The company will also will get a $20 billion cash
infusion from the Treasury Department, adding to the $25 billion the bank
received last month under the Troubled Asset Relief Program.

This is not a particularly good deal for American taxpayers, but it is a
marvelous deal for Citi. In return for all the cash and guarantees they are
giving away, taxpayers will get only $27 billion of preferred shares paying an 8
percent dividend. No other strings are attached. The senior executives of Citi,
including those who have served at the highest levels in the US government, have
done their jobs exceedingly well. The American public, including the media, have
not the slightest clue what just happened.

Meanwhile, more than a million workers in the automobile industry, along with
six million mortgagees, and a millions of Americans who depend on small
businesses and retailers for paychecks, are getting nothing at all.

As I noted the other day, the difference in urgency between saving wall
street and saving main street is apparent.

John Jansen says somebody will pay for this:

Reaction to the Bailout:
Tokyo is closed so there is no US Treasury trading this evening. We will have to
wait for Europe to arrive to get a reaction.

Stocks are higher. That also seems ludicrous. I do not care what they call
this but Citibank is effectively acknowledging that they did not have the
resources to survive alone without government assistance. I did not use the
words bankrupt or insolvent.

I think that when participants think about this soberly they will be very
disturbed and I am saddened to say that the markets will line up one of the
remaining survivors for a pre holiday turkey shoot. It has been the history of
this rolling crisis since August 2007 that the worst outcome ensues. The market
will seek another prey and relentlessly pursue it.

A bailout was necessary — but this bailout is an outrage: a
lousy deal for the taxpayers, no accountability for management, and just to make
things perfect, quite possibly inadequate, so that Citi will be back for
more.

For all of the Depression Mania, there is a lot of the U.S. economy that
does not have to shrink. Manufacturing is pretty lean to begin with. Housing
construction is already much lower than it has been in years. Unlike the 1930's,
we have some very big sectors (health care, education, other government
employment) that are unlikely to develop massive layoffs.

The one sector that definitely needs to contract is the financial sector.
Maintaining Citi as a zombie bank is not really constructive. I would feel
better if it were carved up, with the viable pieces sold to other firms and the
remainder wound down by government. In my view, getting the financial sector
down to the right size ought to be done sooner, rather than later.

From my perspective, the whole TARP/bailout concept is misconceived. The
priority should not be saving firms. The priority should be pruning the
industry. Get rid of the weak firms, and make good on deposit insurance. Then
let the remaining firms provide the lending that the economy needs.

Citigroup has plenty of assets. It has just written too many claims on those
assets. Those holding those claims need to face the reality that their claims
are worth less than they were promised and adjust to that reality. That means
either liquidating the firm, selling off the assets to the highest bidders, or
becoming the new equity holders of the firm. The FDIC can get involved as
needed to manage its contingent liabilities to insured depositors.

If the government is to get involved beyond that, it should be senior debt to
the restructured entity, not preferred equity (i.e. junior to the most junior
debt) to the existing entity.

The US is guaranteeing $306
billion on bad investments (So much for Capitalism without failure). For
Citi, its a great deal — but its a terrible one for taxpayers.

The dividend payment has been restricted to one cent per quarter for 3 years.
Can someone explain why even a penny is allowed?

Where is the “Protection” for the taxpayers? Where are the clawbacks? How
about going after the idiots that bought a third of a trillion dollars worth of
junk, and then got paid large on it? Where is the sense of outrage and
justice?

At what point do taxpayers demand that the people responsible for creating
this mess must pay their pound of flesh?

But even as it addresses these urgent but essentially cyclical matters, the
Obama administration has begun moving on two pressing structural reforms: it
intends to reorganize markets for health insurance to provide universal
coverage, and to take some tentative but long-lasting measures to cope with
climate change.

President-elect Obama’s strategy on the first problem became clear last week
when he chose Tom Daschle to lead the push for universal healthcare as Secretary
of Health and Human Services.

Daschle,.. last spring, in Critical: What We Can Do About the Health-Care
Crisis,... (aided by writers Jeanne Lambrew and Scott Greenberger) described a
broad plan by which to proceed. Forget about trying to spell out the details of
universal health care coverage in a single great omnibus Act of Congress. That
was the approach that failed in 1993, brought down by intense pressure from
interest groups.

Instead, he proposed, create a Federal Health Board (FHB), loosely modeled on
the Federal Reserve System, with a mandate to provide a public framework for a
largely private health-care delivery system. ... [S]uch a board could create
standards that would serve as models for private insurers..., especially in
devising distinctions between basic and supplementary plans.

Leading
the Way in Political Opportunity?: Following up a
previous post on political opportunity in the United States
and Europe, this graph shows the share of seats held by women in the main
legislative body (parliament’s “lower” house) in the U.S. and nineteen other
rich democracies. The data are from the
Inter-Parliamentary Union. Though not far behind France, the United Kingdom,
and Italy, America’s share is one of the lowest. When the new Congress convenes
in January, women will hold just 17% of the seats in the House of
Representatives (and 17% in the Senate). The figure for Germany is 32%. In
Sweden, at the high end, it’s 47%.

A report on how women fared in the 2008 U.S. elections is
here. A good introduction to cross-country differences and
over-time developments is
Women, Politics, and Power, by Pam Paxton and Melanie
Hughes.

Economic writing, however, conveyed a completely different world. Here,
technology was deservedly king. ... In the economists' world, morality should
not seek to control technology, but should adapt to its demands. Only by doing
so could economic growth be assured and poverty eliminated.

We have clung to this faith in technological salvation as the old faiths
waned and technology became ever more inventive. Our belief in the market – the
midwife of technological invention – was the result. We have embraced
globalisation, the widest possible extension of the market economy.

For the sake of globalisation, communities are denatured, jobs offshored, and
skills continually reconfigured. We are told by its apostles that the wholesale
impairment of most of what gave meaning to life is necessary to achieve an
"efficient allocation of capital" and a "reduction in transaction costs".
Moralities that resist this logic are branded "obstacles to progress". ...

That today's global financial meltdown is the direct consequence of the
west's worship of false gods is a proposition that cannot be discussed, much
less acknowledged. One of its leading deities is the efficient market hypothesis
– the belief that the market accurately prices all trades at each moment in
time, ruling out booms and slumps, manias and panics. Theological language that
might have decried the credit crunch as the "wages of sin", a comeuppance for
prodigious profligacy, has become unusable. ...

Mathematical whizzkids developed new financial instruments, which, by
promising to rob debt of its sting, broke down the barriers of prudence and
self-restraint. The great economist Hyman Minsky's "merchants of debt" sold
their toxic products not only to the credulous and ignorant, but also to greedy
corporations and supposedly savvy individuals.

The result was a global explosion of Ponzi finance ... which purported to
make such paper as safe and valuable as houses. ...

The key theoretical point in the transition to a debt-fuelled economy was the
redefinition of uncertainty as risk. Whereas guarding against uncertainty had
traditionally been a moral issue, hedging against risk is a purely technical
question.

We Found the W.M.D., by Thomas Friedman, Commentary, NY Times: ...This financial
crisis is so far from over. We are just at the end of the beginning. ... If I had
my druthers right now we would convene a special session of Congress, amend the
Constitution and move up the inauguration from Jan. 20 to Thanksgiving Day. Forget
the inaugural balls; we can't afford them. Forget the grandstands; we don't need
them. Just get me a Supreme Court justice and a Bible...

Unfortunately, it would take too long for a majority of states to ratify such
an amendment. What we can do now, though, said the Congressional scholar Norman
Ornstein,... is "ask President Bush to appoint Tim Geithner, Barack Obama's proposed
Treasury secretary, immediately." Make him a Bush appointment and let him take over
next week. This is not a knock on Hank Paulson. It's simply that we can't afford
two months of transition where the markets don't know who is in charge or where
we're going. At the same time, Congress should remain in permanent session to pass
any needed legislation.

This is the real "Code Red." As one banker remarked to me: "We finally found
the W.M.D." They were buried in our own backyard - subprime mortgages and all the
derivatives attached to them.

Yet, it is obvious that President Bush can't mobilize the tools to defuse them
- a massive stimulus program to improve infrastructure and create jobs, a broad-based
homeowner initiative to limit foreclosures and stabilize housing prices, and therefore
mortgage assets, more capital for bank balance sheets and, most importantly, a huge
injection of optimism and confidence that we can and will pull out of this with
a new economic team at the helm.

The last point is something only a new President Obama can inject. ... I have
no illusions that Obama's arrival on the scene will be a magic wand, but it would
help.

Right now there is something deeply dysfunctional, bordering on scandalously
irresponsible, in the fractious way our political elite are behaving - with business
as usual in the most unusual economic moment of our lifetimes. They don't seem to
understand: Our financial system is imperiled. ... The stock and credit markets
... have started to price financial stocks at Great Depression levels, not just
recession levels. With $5, you can now buy one share of Citigroup and have enough
left over for a bite at McDonalds.

As a result, Barack Obama is possibly going to have to make the biggest call
of his presidency - before it even starts.

"A great judgment has to be made now as to just how big and bad the situation
is," says Jeffrey Garten, the Yale School of Management professor of international
finance. "This is a crucial judgment. Do we think that a couple of hundred billion
more and couple of bad quarters will take care of this problem, or do we think that
despite everything that we have done so far ... the bottom is nowhere in sight and
we are staring at a deep hole that the entire world could fall into?"

If it's the latter, then we need a huge catalyst of confidence and capital to
turn this thing around. Only the new president and his team, synchronizing with
the world's other big economies, can provide it.

"The biggest mistake Obama could make," added Garten, "is thinking this problem
is smaller than it is. On the other hand, there is far less danger in overestimating
what will be necessary to solve it." ...

There are lots of uncertainties right now. For example, very few of the
econometric estimates we have cover time periods where the conditions we are
seeing today were in effect, so there is uncertainty about the right values to
use in calculations concerning the size of the stimulus (will Okun's law still
hold if firms have excess capacity allowing them to increase production without
adding many new employees?). Many of the estimates are also based upon the
assumption that the unemployment rate will reach 3.5% above normal (without
intervention), but that number is not known with certainty either. You can use
that uncertainty to tell a "maybe it won't be so bad so let's not panic and do a
large stimulus" story, but the uncertainty also works in the other direction and
things could be worse than expected (or the stimulus less could be less powerful
than expected). Since the loss function is asymmetric - doing too little is more
costly than doing too much - we need to be sure that the stimulus is large
enough to provide some degree of insurance against unexpectedly bad outcomes. And the sooner we do this, the better.

Saturday, November 22, 2008

Why Sheila Bair must resign, Bronte Capital: Sheila Bair is doing a fine job
at one thing – modifying mortgage terms in the mortgages she has taken over –
particularly those at Indy Mac. As a liberal I would be expected to applaud –
but I am profoundly glad that Obama did not do as Robert Kuttner suggested and
nominate Sheila Bair for the Treasury Secretary post.

Sheila Bair is simply wrong when she implies that the problem started with
mortgages and therefore it will end with mortgages. The problem with mortgages
is no more than a trillion dollars (say 20 percent of the mortgages in the US
defaulting with a 50% loss). Indeed it is much less than a trillion. If the
financial crisis were about mortgages it would be over now – what with 500
billion of capital raising, a few hundred billion chipped in elsewhere (either
by the Government into AIG or Maiden Lane or by Lehman and Washington Mutual
bond holders and all the Fannie and Freddie losses that will be picked up by the
Feds). The financial crisis is not about mortgages – it is about trust.

The people who provide finance to financial institutions (inter-bank and
otherwise) no longer believe they will get their money back – and so are no
longer willing to provide finance. The unwillingness to lend to financial
institutions dooms them regardless of their solvency. The crisis is about trust.

It is alarming enough that the head of the FDIC in so self serving a manner
misdiagnoses the nature of the financial crisis – self serving because her
institution is building up enviable expertise in modifying mortgage terms.
... But if misdiagnosis of
the crisis were the end of it then there would be no pressing need for Sheila
Bair to resign. It is not the end of it. Sheila Bair is an obstacle – indeed one
of the principal obstacles in the way of reinstalling trust to American
financial institutions.

Richard Green is worried about leaving the choice of where to invest in
infrastructure to the political process:

Public Works, by Richard Green: I watched President-Elect Obama's weekly
address this morning on You-tube, in which he called for a massive public works
programs to help us crawl out of recession.

In principle, this is a very good idea. One of the deficiencies of policy
over the past eight years (and for 20 or the past 28) has been an ideological
denial of the existence and importance of public goods--goods with high fixed
costs, close-to-zero marginal costs (i.e., non-rival), and goods where it is
difficult to exclude. The Republican throwaway lines--you are always better at
spending your own money than the government, and government doesn't solve the
problem, it is the problem--represent the contempt Republicans have for public
goods.

Many public goods, however, are manifestly beneficial to the economy. Even
George Will cites the Interstate Highway System as an unambiguous success. Rural
electrification, which has a heavily subsidized enterprise, was almost certainly
a positive net present value investment for the country, as were the California
aqueducts (or for that matter, the Roman aqueducts). The bridges and tunnels of
New York City helped it become the world's leading city. One could go on and on.

When one looks at the long term insufficiency of our roads, our water
systems, our power grid, our ports and our airports, it is clear that there are
many positive NPV opportunities for government now--particularly in light of the
low cost of long-term Treasury debt.

The problem is that government usually allocates investment funds via a
political process, rather than a feasibility process. Government officials also
often prefer grand, ineffective projects to more pedestrian, effective projects
(transit officials here in LA prefer extended light rail to synchronizing the
traffic lights). So if we are about to spend a lot on public works, I think we
need some sort of non-partisan entity, such as the CBO, that develops a rigorous
capital budget process for determining spending priorities. In the absence of
such a process, we will spend money on negative NPV bridges to nowhere.

Monetary Policy is Key As Milton Friedman and Anna Jacobson Schwartz
argued in a classic book,... the single biggest cause of the Great Depression
was that the Federal Reserve let the money supply fall by one-third, causing
deflation. Furthermore, banks were allowed to fail, causing a credit crisis.
Roosevelt’s best policies were those designed to increase the money supply, get
the banking system back on its feet and restore trust in financial institutions.
...

Today, expansionary monetary policy isn’t so easy to put into effect, as we
are seeing a shrinkage of credit and a contraction of the “shadow banking
sector,”... So don’t expect the benefits of monetary expansion to kick in right
now, or even six months from now.

Still, the Fed needs to stand ready to prevent a downward spiral and to
stimulate the economy once it’s possible.

Get the Small Things Right ...Roosevelt instituted a disastrous legacy
of agricultural subsidies and sought to cartelize industry... Neither policy
helped the economy recover.

He also took steps to strengthen unions and to keep real wages high. This
helped workers who had jobs, but made it much harder for the unemployed to get
back to work. One result was unemployment rates that remained high throughout
the New Deal period.

Today, President-elect Barack Obama faces pressures to make unionization
easier, but such policies are likely to worsen the recession for many Americans.

Don't Raise Taxes in a Slump The New Deal’s legacy of public works
programs has given many people the impression that it was a time of expansionary
fiscal policy, but that isn’t quite right. Government spending went up
considerably, but taxes rose, too. ... When all of these tax increases are taken into account, New Deal fiscal policy didn’t do much to promote recovery.

War Isn't the Weapon World War II did help the American economy, but
the gains came in the early stages, when America was still just selling
war-related goods to Europe and was not yet a combatant. ...

While overall economic output was rising, and the military draft lowered
unemployment, the war years were generally not prosperous ones. As for today, we
shouldn’t think that fighting a war is the way to restore economic health.

You Can't Turn Bad Into Good The good New Deal policies, like
constructing a basic social safety net, made sense on their own terms and would
have been desirable in the boom years of the 1920s as well. The bad policies
made things worse. Today, that means we should restrict extraordinary measures
to the financial sector as much as possible and resist the temptation to “do
something” for its own sake. ...

Our current downturn will end as well someday, and, as in the ’30s, the
recovery will probably come for reasons that have little to do with most policy
initiatives.

For critical responses, perhaps you can try the
comments section at Mark Thoma's. For reasons of space, it was not possible
to specify that I was praising the proposed Obama middle-class tax cut. I do
not, however, think it will do much (if anything) to end the current recession,
although tax hikes could make things worse.

To a large extent, economic recovery will depend on a much clearer sense of
the direction of future economic change. That is largely the job of government.
After the confused and misguided leadership of the administration of US
President George W. Bush, which failed to give any clear path to energy, health,
climate and financial policies, president-elect Barack Obama will have to start
charting a course that defines the US economy’s future direction.

The US is not the only economy in this equation. We need a global vision of
sustainable recovery that includes leadership from China, India, Europe, Latin
America and, yes, even Africa...

There are a few clear points amidst the large uncertainties and confusions.
First, the US cannot continue borrowing from the rest of the world as it has for
the past eight years. The US’ net exports will have to increase... The
adjustments needed amount to ... about US$700 billion in the US current account,
or nearly 5 percent of US GNP. ...

Second, the decline in US consumption should also be partly offset by a rise
in US investment. However, private business will not step up investment unless
there is a clear policy direction for the economy. Obama has emphasized the need
for a “green recovery,” that is, one based on sustainable technologies, not
merely on consumption spending.

The US auto industry should be retooled for low carbon emission automobiles,
either plug-in hybrids or pure battery-operated vehicles. Either technology will
depend on a national electricity grid that uses low emission forms of power
generation, such as wind, solar, nuclear, or coal-fired plants that capture and
store the carbon dioxide emissions. All of these technologies will require
public funding alongside private investment.

Third, the US recovery will not be credible unless there is also a strategy
for getting the government’s own finances back in order. Bush’s idea of economic
policy was to cut taxes three times while boosting spending on war. The result
is a massive budget deficit, which will expand to gargantuan proportions in the
coming year...

Obama will need to put forward a medium-term fiscal plan that restores
government finances. This will include ending the war in Iraq, raising taxes on
the rich and also gradually phasing in new consumption taxes. The US currently
collects the lowest ratio of taxes to national income among rich nations. This
will have to change.

Fourth, the ... World Bank, the European Investment Bank, the US
Export-Import Bank, the African Development Bank and other public investment
funds should be financing large-scale infrastructure spending in Africa to build
roads, power plants, ports and telecommunications systems. ... The benefits
would be extraordinary for both Africa and the rich countries...

In typical business cycles, countries are usually left to manage the recovery
largely on their own. This time we will need global cooperation. Recovery will
require major shifts in trade imbalances, technologies and public budgets.

These large-scale changes will have to be coordinated, at least informally if
not tightly, among the major economies. ... We have arrived at a moment in
history when cooperative global political leadership is more important than
ever. Fortunately, the US has taken a huge step forward with Obama’s election.
Now to action.

One must, however, challenge all accepted attitudes on the next point. It is
that recession is uniformly adverse in its effect and thus by everyone deplored.
A great many people and an even higher proportion of those who have political
voice and vote, though perhaps not a majority, find a recession quite
comfortable, and certainly more so than the measures that do anything effective
about it. This, however, no one dreams of saying.

Economists and all approved economic doctrine have made high employment and
economic growth a sacred good. With this no one can openly disagree.

There are the many who live in recession with a wholly secure livelihood and
with a lessened fear of price increases, of inflation. They are in no real
danger of loss or diminution of income. Present here are the more secure parts
of the modern corporate bureaucracy. ...

Similarly secure are many in the professions, professors, needless to say,
some public servants, lawyers, doctors and media stars. Also very important is
the modern large rentier class. And many who live on Social Security or
pensions.

For all these, recessions mean stable or even falling prices and no serious
reduction of income. ...

Also, in an economy where services are increasingly important, a recession
means a more willing and pliant labor supply, an underclass more available for
the unpleasant toil that makes life for the rest of us more agreeable. And for
employers.

A recession in modern times is also for many far more attractive than
remedial action against it.

The possible positive lines of action against recession are three: taxes can
be reduced to enhance the flow of consumer and investment spending, or so it is
hoped; interest rates can be lowered to enhance investment spending and consumer
purchases of houses, automobiles, refrigerators and electronics, or so it is
also hoped; the Government can undertake direct, forthright job creation. This
is the holy trinity. Prayer and repetitive prediction of recovery apart, there
are no other lines of action.

Tax reduction has its proponents, notably among those who pay the taxes.
Unfortunately, its relation to recovery is theoretical. There is the difficult
question as to whether the revenues released will be spent or invested; they may
be held as cash or unused bank balances. And tax reduction would increase the
deficit, concern with which has now reached near paranoiac proportions. Again,
better the recession.

Next, there is monetary policy: the reduction of interest rates by the
Federal Reserve. This is believed to have a peculiar magic. It calls for no big
bureaucratic effort, carries no threat of taxes -- and a special intelligence is
taken to characterize those who are associated occupationally with money.

But monetary policy works against recession by reducing interest rates and
therewith rentier income. This is by no means welcomed by those who enjoy such
income. They are not without political influence. Any talk of an easier monetary
policy automatically brings grave and urgent warnings of the danger of
inflation. This, too, is a threat to those on stable incomes.

Additionally, there is the sad fact that in a recession monetary policy
doesn't work. The elasticity of the response to reduced interest rates is then
very low. People and firms spend and invest, or fail to do so, pretty much as
before.

Finally, there is direct Government expenditure and employment. For those
resting comfortably in recession, this is the worst of all. It could raise
prices, risk inflation. Much worse, it promises higher taxes at some time yet to
come. ...

We pride ourselves in being plain-spoken, free from cant and certainly from
any pathological self-delusion. Given a fact, we face it. Let us now face the
fact that for many a recession is a tolerable, even pleasant thing. And let us
say so. This will not be popular. There could be indignant denial. That is often
the response to unwelcome truth.

Assessing the impact of
the financial crisis on the US labour market, by Peter Auer, Raphael Auer, and
Simon Wehrmüller, VoxEU.org: ...In this column, we examine the extent to
which the high cost of obtaining external funds has affected employment in US
industries... We document that employment in sectors that are relatively more in
need of external finance has indeed decreased to a much larger extent than
employment in sectors less dependent on external sources of financing. In the
aggregate, our results suggest that the increasing cost of external finance can
account for much of the decline in employment witnessed in US industry since
August 2007. ...

Conclusion ... We are now witnessing the start of
potentially
severe real consequences of the financial crisis. Our results suggest that
much of these real consequences are driven by credit constraints rather than
negative demand shocks or layoffs in sectors that are directly affected by the
crisis.

Consequently, our results strengthen the case for measures aimed directly at
restoring well-functioning financial markets. However, while reconstructing
sustainable financial systems will be necessary, this alone will most probably
not be sufficient for leading out of the crisis. Indeed, as the financial crisis
enters more deeply into the real economy, also aggregate demand falters, which
may justify demand-supporting policies. ...

While freeing financial markets will certainly help, at this point we need a fiscal stimulus package, and we needed it to be in place months ago. I am disappointed that Congress is not giving the employment crisis the same amount of attention and concern that has been given to the financial sector. This is an economic emergency and every day that we wait to put a fiscal stimulus package in place costs more jobs and ruins more lives. There's no excuse for taking those lives lightly. Congress needs to be working on this night and day, Democrats need to use every means at its disposal to round up the votes needed to override a potential veto from Bush, and they need to use public opinion to pressure Bush to sign the bill once it is ready (and why isn't it ready now?). It may be fruitless presently given the administration's opposition to offering the help that is needed, but the situation is dire and that's not an excuse not to try. If there is strong public support for action, who knows, the administration may come around. In any case, by starting now we are more likely to have the stage set for immediate action once the new administration takes over. Even if the plan is vetoed, having the necessary debate and getting the stimulus package ready now lets those who will be responsible for implementing the plans once the new administration takes over know the broad outlines of what will be done, and this will give then a head start in planning for action. There's no time to waste.

The outlook for the economy is deteriorating, yet economic policy "seems to have gone
on vacation":

The Lame-Duck Economy, by Paul Krugman, Commentary, NY Times: Everyone’s
talking about a new New Deal, for obvious reasons. In 2008, as in 1932, a long
era of Republican political dominance came to an end in the face of an economic
and financial crisis that, in voters’ minds, both discredited the G.O.P.’s
free-market ideology and undermined its claims of competence. And for those on
the progressive side of the political spectrum, these are hopeful times.

There is, however, another and more disturbing parallel between 2008 and 1932
— namely, the emergence of a power vacuum at the height of the crisis. The
interregnum of 1932-1933, the long stretch between the election and the actual
transfer of power, was disastrous for the U.S. economy, at least in part because
the outgoing administration had no credibility, the incoming administration had
no authority and the ideological chasm between the two sides was too great to
allow concerted action. And the same thing is happening now. ...

How much can go wrong in the two months before Mr. Obama takes the oath of
office? The answer, unfortunately, is: a lot. ... The prospects for the economy
look much grimmer now than they did as little as a week or two ago.

Yet economic policy, rather than responding to the threat, seems to have gone
on vacation. In particular, panic has returned to the credit markets, yet ...
Henry Paulson ... has announced that he won’t even go back to Congress for the
second half of the $700 billion already approved for financial bailouts. And
financial aid for the beleaguered auto industry is being stalled by a political
standoff. ...

What’s really troubling ... is the possibility that some of the damage being
done right now will be irreversible. I’m concerned, in particular, about the two
D’s: deflation and Detroit.

About deflation: Japan’s “lost decade” in the 1990s taught economists that
it’s very hard to get the economy moving once expectations of inflation get too
low (it doesn’t matter whether people literally expect prices to fall). Yet
there’s clear deflationary pressure on the U.S. economy right now, and every
month that passes without signs of recovery increases the odds that we’ll find
ourselves stuck in a Japan-type trap for years.

About Detroit: There’s now a real risk that, in the absence of quick federal
aid, the Big Three automakers and their network of suppliers will be forced ...
to shut down, lay off all their workers and sell off their assets. And if that
happens, it will be very hard to bring them back.

Now, maybe letting the auto companies die is the right decision, even though
an auto industry collapse would be a huge blow to an already slumping economy.
But it’s a decision that should be taken carefully, with full consideration of
the costs and benefits — not a decision taken by default, because of a political
standoff between Democrats who want Mr. Paulson to use some of that $700 billion
and a lame-duck administration that’s trying to force Congress to divert funds
from a fuel-efficiency program instead.

Is economic policy completely paralyzed between now and Jan. 20? No, not
completely. Some useful actions are being taken. For example, Fannie Mae and
Freddie Mac ... have taken the helpful step of declaring a temporary halt to
foreclosures, while Congress has passed a badly needed extension of unemployment
benefits now that the White House has dropped its opposition.

But nothing is happening on the policy front that is remotely commensurate
with the scale of the economic crisis. And it’s scary to think how much more can
go wrong before Inauguration Day.

This research concludes that "global warming will be a major problem even
under very optimistic circumstances":

Uncertainty, climate
change, and the global economy, by Torsten Persson and David von Below,
VoxEU.org: What will the climate be like in a hundred years’ time? The
answer to this question is highly uncertain, and will depend on a number of
socio-economic as well as natural processes, which describe the links between
human activity, emissions of greenhouse gases, and warming of the atmosphere.
The existing policy discussion in important forums, such as the IPCC and Stern
reports (see this Vox column), is largely based on the uncertainty about the
biogeophysical and biogeochemical systems, as are analyses such as that of
Wigley and Raper (2001). In a recent
paper, we include such uncertainty – but highlight uncertainty about the
drivers of climate change in the socioeconomic system. [...continue reading...]

Thursday, November 20, 2008

Policy Adrift, by Tim Duy: I understand the Federal Reserve Chairman Ben Bernanke is considered
something of a sacred cow, our one point of light in an uncertain world. An
academic who cannot be questioned by other academics. A smart person who has
mastered the Great Depression and therefore “knows” what to do, and is providing
the leadership to do it.

I am beginning to question all of these assumptions.

I am hoping Bernanke can step forward and clarify the direction of policy. At
this moment, he has the best perch from which to guide policy between
administrations. He has the opportunity to show leadership. But for now, I see a
distinct lack of leadership from the Federal Reserve, and it suggests that
Bernanke has used up his bag of tricks. And I don’t think that he knows what to
do next. Indeed, Fedspeak is now littered with confusing statements that leave
the true policy of the Federal Reserve in question.

First, policymakers appear uncertain about what to do with the Fed Funds
target. The minutes of the most recent meeting tell the story:

An Auto
Bailout Would Be Terrible for Free Trade, by Matthew Slaughter, Commentary, WSJ:
Congress is now considering a federal bailout for America's Big Three automobile
companies. Many want to grant them at least $25 billion ... on top of $25
billion in low-interest loans approved earlier this year. ... There are at least
three important ways an industry bailout could damage America's engagement in
the global economy and hurt U.S. companies, workers and taxpayers.

The first global cost of a bailout could be less foreign direct investment (FDI)
coming into the United States. ...

Will fewer companies look to insource into America if the federal government
is willing to bail out their domestic competitors?

The answer is an obvious yes. Ironically, proponents of a bailout say saving
Detroit is necessary to protect the U.S. manufacturing base. But too many such
bailouts could erode the number of manufacturers willing to invest here.

The bailout's second global cost could hit U.S.-headquartered companies that
run multinational businesses. ...

Will a U.S.-government bailout go ignored by policy makers abroad? No. A
bailout will likely entrench and expand protectionist practices across the
globe, and thus erode the foreign sales and competitiveness of U.S.
multinationals. ... That would be bad for America.

Rising trade barriers would also hurt the Big Three, all of which are
multinational corporations that depend on foreign markets. ...

The bailout's third global cost could fall on the U.S. dollar. ... Will a
federal bailout that politicizes American markets bolster foreign-investor
demand for U.S. assets?

Not likely. Instead, America runs the risk of creating the kind of
"political-risk premium" that investors have long placed on other countries --
and that would reduce demand for U.S. assets and thereby the value of the U.S.
dollar. ...

This week Congress is weighing the cost of the bailout. Let us hope that
lawmakers realize that the true cost of such a bailout is far larger than any
check the U.S. Treasury will have to write in the coming months.

Many foreign companies are highly dependent upon the general state of the
U.S. economy, especially, of course, those operating within our borders. There
is also an argument that bailing out the automakers is in the interest of these companies because it lowers the chances of a
prolonged, deep recession that would substantially reduce their sales and profits.

What’s the Value of a Big Bonus?, by Dan Ariely, Commentary, NY Times: By
withholding bonuses from their top executives, Goldman Sachs and UBS may soften
negative reaction from Congress and the public... But will they also suffer
because their executives, lacking the motivation that big bonuses are thought to
provide, will not do their jobs well? ...[D]oesn’t the promise of a big bonus
push people to work to the best of their ability?

To look at this question, three colleagues and I conducted an experiment. We
presented 87 participants with an array of tasks that demanded attention,
memory, concentration and creativity. ... We promised them payment if they
performed the tasks exceptionally well. About a third of the subjects were told
they’d be given a small bonus, another third were promised a medium-level bonus,
and the last third could earn a high bonus.

We did this study in India, where the cost of living is relatively low so
that we could pay people amounts that were substantial to them but still within
our research budget. ...

What would you expect the results to be? When we posed this question to a
group of business students, they said they expected performance to improve with
the amount of the reward. But this was not what we found. The people offered
medium bonuses performed no better, or worse, than those offered low bonuses.
But what was most interesting was that the group offered the biggest bonus did
worse than the other two groups across all the tasks.

We replicated these results in a study at the Massachusetts Institute of
Technology... We found that as long as the task involved only mechanical skill,
bonuses worked as would be expected... But when we included a task that required
even rudimentary cognitive skill, the outcome was the same as in the India
study: the offer of a higher bonus led to poorer performance.

If our tests mimic the real world, then higher bonuses may not only cost
employers more but also discourage executives from working to the best of their
ability. ... For most bankers, a multimillion-dollar compensation package could
easily be counterproductive. ...